Chazen Global Insights

Emerging Markets: Nirvana Lost

For emerging markets, nirvana is over; but, in some cases, their citizens have no inkling of the suffering that may be upon them, says the former finance minister of Chile and a visiting professor at Columbia University.

In the 1970s, the great Yale University economist Carlos Díaz-Alejandro used to say that the combination of high commodity prices, low world interest rates, and abundant international liquidity would amount to economic nirvana for developing countries. Back then, no sensible economist believed that such a state of grace could ever arrive. Yet arrive it did, and over the last decade commodity-rich countries like Brazil, Indonesia, Russia, and South Africa enjoyed its abundant benefits with abandon.

But now nirvana seems to be ending: commodity prices are down, and the mere possibility that the US Federal Reserve may end its policy of quantitative easing has raised market interest rates in the rich countries and sent funds fleeing from once-fashionable emerging markets back to safe havens in the North. Stock markets and currencies are plunging, and not just in commodity-rich emerging countries but also in others, like India and Turkey, that had sucked in huge flows of foreign capital. Pessimists are already seeing a replay of the late-1990s Asian crisis or, worse, an emerging-market echo of the 2008-2009 crisis in the advanced countries.

What the hardest-hit economies have in common are large external deficits. Abundant capital inflows caused their exchange rates to appreciate, making imports cheap and unleashing consumption (and sometimes investment) booms that eroded their trade balances, even as rising commodity prices boosted the value of their exports. Now the cycle is being reversed and exchange rates must depreciate to facilitate external adjustment. Anticipating that change — and the prospect of higher interest rates closer to home – foreign investors are taking flight, hastening and sharpening the exchange-rate plunge.

That is the bad news. The good news (fingers crossed) is that a full-fledged emerging-market financial crisis is unlikely. For one thing, this time was different with regard to fiscal behavior, as Luis Felipe Céspedes and I show in a recent paper.

Commodity-rich governments did not spend the entire windfall and more, as they had done during earlier commodity booms. So government debt and the resulting financial vulnerability are not as high as they were in the past.

These countries’ private sectors have borrowed significantly; but, as the Nobel laureate economist Paul Krugman has been pointing out, leverage and dollar debt are lower (as a share of national income) than they were at the outset of the 1990s Asian crisis — and at the start of the 1980’s Latin American crisis, for that matter.

So, in my view, the question is not whether these countries’ financial sectors will explode but whether their growth trajectories will implode.

When commodity prices are sky-high and money is cheap and plentiful, economic growth is almost inevitable. In Latin America over the last decade, countries with sound macroeconomic policy frameworks, like Colombia, Peru, and Chile, grew rapidly. But so did Argentina, a country whose government seems to start every day wondering what more it can do to weaken economic institutions and damage long-term growth prospects.

Now that nirvana is over, where will growth come from? To answer that question, it helps to note, as Harvard University’s Ricardo Hausmann has done recently, that some of the emerging economies’ recent growth was illusory. Wall Street became enamored with the rapidly rising dollar value of these countries’ national income, but that rise had more to do with strong commodity prices and appreciating exchange rates (which raised the value of their output when measured in dollars) than with sharp increases in actual output volumes.

During the boom years, structural transformation in many emerging economies, particularly in Latin America, was limited. Countries like Ireland, Finland, and Singapore — and also South Korea, Malaysia, and Indonesia — export different goods (and to different markets) than they did a generation ago. By contrast, Chile’s export basket is pretty much the same as it was in 1980.

There is nothing wrong with exporting copper, wine, fruit, and forest products. But economic history suggests that countries seldom — if ever — get rich by doing just that. Commodity-rich advanced economies like Canada, Norway, or Australia export lots of natural resources, of course, but they also export many other goods and services. That is not true of Chile, Peru, or Colombia — or even of Brazil, with its much larger population and more developed industrial base.

To make matters worse, unlike their Asian counterparts, Latin America’s economies are not integrated into regional and global value chains. A producer in Indonesia, Malaysia, or the Philippines can easily take advantage of the local currency’s depreciation to sell more electronic components to an assembly plant in China with which it has a long-standing and well-developed supply relationship. A business in Concepción, Arequipa, or Medellín, by contrast, must seek new customers in new countries, which takes time and money — and may not succeed.

Latin American governments could have used the opportunities afforded by the global commodity and liquidity booms to diversify their economies, working with local business communities to move into new products and sectors. They did not.

In some of these countries, conservative governments viewed industrial promotion as some dirigiste relic from the past, and avoided it. In others — Brazil comes to mind — left-leaning governments practiced industrial promotion in such a heavy-handed and erratic way that they ended up weakening whatever it was they wanted to promote. The time has come to pay for these mistakes.

Nirvana is defined as the state of freedom from suffering. For emerging markets, that state is over; but, in some cases, their citizens — still feeling rich from cheap money and high export prices — have no inkling of the suffering that may be upon them. For the sake of political stability, governments would be well advised to inform them.

Andrés Velasco, a former finance minister of Chile, is a visiting professor at Columbia University’s School of International and Public Affairs.